Disclaimer: My background is mathematics, not economics/finance/trading, so this post isn't written by an expert, and shouldn't be regarded as an investing advice. Also it has absolutely nothing to do with the recent price spike/China.Often people say that Bitcoin price is affected by supply and demand. But what are they, exactly? Supply and demand model is useful when one can define supply & demand curves, but that's quite problematic in case of Bitcoin: quite often people do not look to buy a specific amount of bitcoins, but instead want to convert certain amount of dollars into bitcoins, thus the demand curve is pretty much undefined.So let's consider it from first principles instead: What is a price, in general? It's the ratio of the quantities of goods that are exchanged for each other. So e.g. if one buys 3 bitcoins for 1500 dollars, then price of one bitcoin in dollars is 1500 / 3 = 500 dollars. So a bitcoin price in one transaction is quantity of dollars divided by quantity of bitcoins exchanged in said transaction.Now we can calculate an average price on a specific date by averaging the price of bitcoin in transactions which happened on that date. It makes sense to use a weighted average, as we don't want small trades to distort the picture. But if we use bitcoin quantity as a weight, then the average price will be the same as if we would just sum all trades together. Indeed, suppose d1 and d2 are dollar quantities in transactions 1 and 2, and b1 and b2 are bitcoin quantities. Price in transaction 1 is d1/b1 and its weight is b1/(b1+b2). Then: (b1/(b1+b2))*(d1/b1) + (b2/(b1+b2))*(d2/b2) = d1/(b1 + b2) + d2/(b1+b2) = = (d1 + d2)/(b1 + b2) So, e.g. if 15 million dollars were used to buy 30000 bitcoins on a particular date on a particular exchange, then the average weighted price is 500 dollars per bitcoin, regardless of what individual transactions were made and how price fluctuated during the day.Now if 18 million dollars were used to buy the same bitcoin amount, the price would be higher: 600 dollars per bitcoin.Thus we can mathematically prove a very simple concept I bet everybody understands intuitively: the more dollars people use to buy bitcoins, the higher is the bitcoin price.Note that we can also use this approach to calculate an average price over the month/year/etc.This model makes it easy to understand the nature of Bitcoin "bubbles": a lot of dollars were used to buy bitcoins over a short interval of time. As simple as that...To elaborate on this, investing decisions people make are likely to be highly correlated. E.g. imagine some random guy who bought bitcoins during the Spring 2013 bubble. Why did he do that? He probably read some articles about Bitcoin and thought: "Oh, this might work, it's probably a good idea to use that spare thousand dollars i have to buy some bitcoins". But other people who have similar background/mindset/views are reading the same articles and thus are likely to make same decisions. Of course, people aren't identical, thus the process is spread over months. Now suppose John wants to spend $1000, Jane wants to spend $10000 etc, and if we sum it all together we'll get $100M.The price of bitcoin over will depend on how many bitcoins will be sold. If we assume a simplified model in which only mined bitcoins are sold, then that quantity is fixed, and thus price will be determined by the demand (i.e. how much people are going to spend on buying bitcoins).In reality, of course, it's much more complex, as there is a number of positive and negative feedback loops:positive: when price goes up, more articles appear and more people become aware of it and want to investpositive: FOMO (fear of missing out)negative: as price goes higher, people start to think that bitcoin is overpriced, it's a bubble, etc, and thus are reluctant to investnegative: as price goes higher, existing bitcoin holders will consider selling to take profit/diversify/time the market etc., thus increasing the available supplypositive: people who buy things for bitcoin need to sell fewer bitcoins to buy them (or need to spend fewer bitcoins)positive: miners need to sell fewer bitcoins to pay for electricity & harwareSo it's not possible to predict bitcoin price as many effects are at play, however, we can observe that generally supply is rather limited (as there are so many bitcoins people consider selling, at any price) and inelastic; while the demand isn't so limited, thus we have this rapid price spikes.(Sidenote: one might notice that we aren't accounting for day trading, market making, arbitrage and so on. It can be demonstrated mathematically that while day trading and market making increase the trading volume, they don't really have a significant effect on price, essentially they just smooth out the price fluctuations.)The model can also explain a prolonged price fall after the spike. As was mentioned above, investment decisions are correlated, so after a period of high activity we have period of low activity when few people buy bitcoins as an investment. Basically, after all people who wanted to buy bitcoins bought them, we no longer have massive amounts of dollars being poured into Bitcoin markets. (Note that here we assume that most people prefer lump sum investment approach rather than periodic investment like dollar-cost averaging.)So the demand falls rapidly, but the supply is still there. Let's consider effect on the price which different users have:positive: people who do periodic investing like dollar cost averagingpositive: people who buy while price is falling, believing that they can time the marketpositive: people who are late at a party and suddenly decide they actually want bitcoinsnegative: people spending bitcoinsnegative: people who panic-sell or want to fix profit/lossnegative: miners selling bitcoins to pay for electricity, rent, hardwareneutral: holdersneutral: people who spend bitcoins to buy goods (assuming merchants sell those bitcoins)Apparently, negative factors vastly outweigh the positive ones: there just aren't too many slowpoke people, and people trying to buy at bottom can only try that once. So you basically have periodic buyers vs miners selling bitcoins, and miners sell a lot, so usually we have a huge price collapse after the spike.If we care about bitcoin price stability, we should observe the following:Hodling doesn't really help to stabilize the price. Obviously, it's better than panic-selling, and in that context it makes a lot of sense. However, by itself it's neutral.Periodic buying, such as dollar-cost averaging helps to stabilize the price as: a) it helps to avoid a huge spike as fewer dollars are poured into markets over a short time frame; b) it's pretty much the only factor which holds bitcoin price after the spikeSo my conclusion is: dollar-cost averaging is good for Bitcoin, as it helps to stabilize the price. If you agree with my conclusions please help to spread the word.(Dollar-cost averaging means buying periodically with the same amount of fiat currency regardless of price, e.g. each week you buy $100 worth of bitcoins.)Note that dollar-cost averaging isn't necessarily a good strategy for an individual, as investing theorists say that other strategies, such as lump sum, are better. Also it usually means more hassle.But buying a lump sum while price is rising has the worst effect on price stability, while periodic buying (not necessarily DCA) help to stabilize the price. via /r/Bitcoin http://bit.ly/1sFMuE3
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